Labor could learn from eurozone facing mutually assured distrust

Kudelka cartoon

COUNT on Julia Gillard to lecture Europe about fiscal rectitude when at 3.4 per cent of gross domestic product, our 2011 structural budget deficit is twice Germany's, a third larger than Italy's and only a fraction smaller than France's.

And count on her to endorse Barack Obama's economic program when there is no sign of the US fiscal position coming back under control.

Rather, on almost any indicator, the Europeans show greater signs than the Americans of taking fiscal disciplines seriously.

European budget deficits are being cut, including through reductions in wasteful public spending. Moreover, in virtually every European country, independent fiscal authorities are being created or strengthened, adding credibility to budget commitments. And in some countries, fiscal constraints will be given constitutional status, as France's President Sarkozy has proposed.

Yet none of that detracts from the fact that Greece's debt problems have thrown Europe into a deep, virtually existential, crisis.

That is in some respects puzzling. After all, Greece is a trivially small economy, and even the European banks' exposures to Greek debt are a rounding error compared with their overall assets. While Greece's collapse would clearly impose large costs on its population, it no more threatens Europe than a profound crisis in Tasmania could undo Australia. Dealing with such a collapse should be easy for an economy as large and prosperous as the eurozone's.

Yet Greece's woes have exposed tensions that lie at the heart of the euro project, as they have forced the eurozone's members to grapple with four seemingly irreconcilable constraints.

First, given the great heterogeneity of the eurozone, it is inevitable that the euro's exchange rate will at times prove completely inappropriate for some of its economies, causing serious damage to their trade-exposed industries.

Second, in the absence of financial transfers from those parts of the eurozone that are doing well, the resulting political pressures in the weaker economies could lead them to renege on their pledges of fiscal virtue. This would ultimately threaten the credibility of the eurozone's commitment to price stability, as the weaker countries press for higher inflation not only as a way of lowering the exchange rate but also and especially to erode the value of mounting public debt.

But third, financing such transfers requires a willingness by taxpayers in countries that are doing well to support living standards in the countries that are struggling. The more those taxpayers believe the pain being suffered in the weaker countries is self-inflicted, the less willing they will be. And the lack of trust will be accentuated by the fact that providing such aid itself encourages countries to be profligate.

Yet fourth and last, overcoming mistrust, and neutralising the moral hazard the availability of support funds would create, require mechanisms for supranational fiscal surveillance so intrusive as to conflict with continued national sovereignty and the budgetary supremacy of national parliaments. That supremacy is enshrined in several eurozone countries' constitutions, and attempts to undermine it would be vulnerable to challenge in Europe's increasingly assertive constitutional courts.

Those constraints form a circle that cannot be squared. The conditions that allowed them to be dealt with in large and diverse federations, such as Australia, Canada and the US, do not exist in Europe and are unlikely to fall into place. That is why the euro was a mistake; but having been made, it is

likely to persist, along with the economic tensions it creates. Sure, European governments will come up with ways of papering over the cracks, as they did yesterday. But whatever rabbits they pull out of the hat, the eurozone will remain mired in Mutually Assured Distrust, with assistance to countries in difficulty made available only when circumstances are dire and in exchange for draconian fiscal retrenchment. If eurozone countries insure each other, in other words, it will be with steep deductibles attached.

So far, however, those deductibles are being paid. It is easy to scoff at "club med", but socialist for socialist, Greece's George Papandreou and Spain's Rodriguez Zapatero have shown far greater political courage than Gillard. And even Berlusconi, whatever his antics, has engaged a fiscal consolidation that will largely eliminate Italy's structural deficit in about the same time frame as Australia's -- and that without a once-in-a-century mining boom.

Yes, whether those efforts can be sustained is uncertain. But despite noisy demonstrations, European voters seem increasingly aware of the need for countries to live within their means. Although many political leaders will lose office, their successors will therefore still face pressures to prove their fiscal credentials. Moreover, bond markets, as they are forced to share the pain associated with writing down Greece's debt, should become more cautious, tightening the disciplines on spendthrift governments.

None of this means Europe's problems will disappear. Rather, with rising taxes and entrenched labour market rigidities, Europe seems set to experience a prolonged phase of slow growth, much as Japan's lost decade. But at least credible steps are being taken to bring public debt under control.

Which brings us back to Obama, whose main success to date has been in printing money. No doubt, the fiscal legacy he received from George W. Bush was lamentable; yet he has not even articulated a plausible strategy for resolving America's fiscal crisis, much less shown any capacity to implement it. The US economy is a formidable engine, whose recovery may accelerate in the months ahead. But that could merely reduce the pressure on Obama to address the US's ever-rising public debt. And paradoxically, European fiscal consolidation will free up substantial global savings to fund America's public spending habit, encouraging US procrastination, with all the threats it poses to the world economy.

Labor criticised John Howard for not being tough enough on the US. Obama's visit gives Gillard a chance to show she is made of sterner stuff. First, however, she should start getting her own house in order. And who knows? Even the Europeans might have some lessons for her in that regard.